Shariah Governance and Assurance Index in Islamic Banks in GCC Countries

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1. SHARIAH GOVERNANCE AND ASSURANCE INDEX IN ISLAMIC BANKS IN GCC COUNTRIES Zurina Shafii Associate Professor , Faculty of Economics and Muamalat & Fellow, Islamic Finance and Wealth Management Institute (IFWMI) Universiti Sains Islam Malaysia, 71500, Nilai, Negeri Sembilan, Malaysia 006 06- 798 6325 zurina.shafii@usim.edu.my, anakshafii@yahoo.com Abdullah Ahmed Mohammed Senior lecturer, Faculty of Economics and Muamalat Universiti Sains Islam Malaysia, ;71500, Nilai, Negeri Sembilan, Malaysia abdullah.mohammed@usim.edu.my Supiah Salleh, Senior lecturer, Faculty of Economics and Muamalat Universiti Sains Islam Malaysia, 71500, Nilai, Negeri Sembilan, Malaysia chuyah@usim.edu.my ABSTRACT The primary objective in the establishment of Shariah governance in the IFIs is to enhance the role of the Board, the Shariah Committee and the management in relation to Shariah matters. Shariah Governance and assurance is vital to ensure compliance to Shariah as well as for the promotion of equality, accountability and transparency. For the Shariah governance to be in place, an IFI must ensure the Shariah assurance function to be carried out through the Shariah review and Shariah audit functions. To date, only a limited number of studies on Shariah assurance practices in GCC countries. There are arguments on how, why, who, when and what should be the best practices of Shariah assurance mechanisms to be applicable for adoption in GCC countries. This study identifies Shariah governance and assurance practices in Islamic banks in GCC countries; Bahrain, Saudi Arabia, Kuwait, UAE and Qatar. This study adopts both qualitative and quantitative techniques. For the first stage of analysis, content analysis technique is performed to analyse data from Shariah Committee Reports and annual reports of Islamic banks in GCC countries. Upon the analysis and identification of Shariah assurance practices in GCC countries, the study computes an Index on Shariah Governance and Assurance practices by each of the banks under analysis, benchmarking the exercises against best practices derived from recommendations from relevant fatwa issuing bodies namely Majma’ Fiqh Academy, KFH resolutions and Malaysia’s Shariah Governance Framework. The result of the analysis found that practitioners in different jurisdictions adopt distinctive Shariah governance and Shariah assurance mechanisms. The results from this study are useful for regulators in the Islamic banking industry in GCC to devise proper Shariah governance and assurance mechanisms, which in turn facilitates economic growth and development within the region. Keywords: Shariah governance, Shariah assurance, Islamic finance, Islamic banking. 1
2. I . INTRODUCTION Shariah Governance and audit is one of the vital elements of corporation as it promotes principles of accountability, transparency and Shariah assurance of IFIs to the stakeholders. However, the studies conducted on the practice of Shariah review and audit in the jurisdictions adopting Islamic finance revealed that both functions are conducted inconsistently. Many jurisdictions are yet to offer independent Shariah assurance as they only managed to perform Shariah review function. Shariah review serves as compliance function that provide review to the management on the state of IFIs’ Shariah compliance. Shariah audit, on the other hand, is an independent exercise that aims to examine the effectiveness of the internal control for Shariah compliance within the organization. Both of the functions serve as the Shariah assurance mechanisms that ensure robust practice of Shariah-compliant activities. To assure that IFIs are observing the Shariah principles at all times, there is a need for Shariah auditing and assurance in terms operations and outcomes (Ayedh and Echchabi, 2015). Moreover, there is a significant increase in the voices calling for standardization the Shariah auditing practices in IFIs industry. The governance mechanisms in Islamic finance industry in the Gulf countries (Saudi Arabia, the United Arab Emirates (UAE), Kuwait, Bahrain, Oman and Qatar) shows significant gap. This may be due to the gap of the adoption of Islamic finance in the gulf countries. The first Islamic bank was Dubai Islamic Bank in UAE which launched on 1974 and lately Oman welcomed Islamic banking just in 2013 (IRTI report, 2015). In addition, the Islamic banking regulations are not same among the GCC member countries. For instant, Bahrain banking system is fully Islamic, whereby other GCC countries are not. Therefore, it is expected that the Shariah governance and the Shariah assurance practices is varied among the GCC countries Islamic banks. This issue of members’ countries of GCC drive the intention of the researchers to examine the Shariah auditing practices in IBs in GCC countries. Thus, the study aim to identify the practice of Shariah audit among GCC countries, namely Bahrain, Saudi Arabia, Kuwait, UAE and Qatar and in Islamic Development Bank’s member countries where Islamic finance is adopted as part of the mainstream finance, i.e. Sudan, Pakistan, Indonesia and Malaysia. Upon identifying the practice of Shariah assurance mechanisms, this study computes an Index on Shariah Governance and Assurance practices to provide the analysis of for the practice of Shariah assurance practices in the countries under analysis. 2
3. The remainder of the paper is organised as follows : Section two reviews the past related studies. Section three provides an overview on the Islamic banking industry in GCC. Section four presents the methodology applied in the study and section five discusses the main findings and their implications. The final section provides a detailed discussion of the findings and corresponding limitations, as well as some recommendations for future studies. II. Literature Review 2.1 Definition and Scope of Shariah Audit The term Shariah audit (‫ )اﻟﺘﺪﻗﻴﻖ اﻟﺸﺮﻋﻲ‬is a relatively new term (Chik, 2011). Islamic religious auditing or Shariah audit monitors the performance of IFIs’ state of Shariah compliance. For example, the Islamic Shariah prohibits, among other things, the payment and receipt of riba or usury (Quran 2: 275-276), gambling (Quran 5:90), hoarding (Quran 9:34) and speculation (Qureshi, 1976). Besides that, Islam also forbids any investing or dealing in alcohol, pork and other activities which are considered unlawful from the Islamic perspective. The need for Shariah audit stems from the requirement that the IFI should comply with the Shariah. If religious auditors find any violation of the Islamic principles in the operation of organization, then this should be reported as in the case of external auditor reporting their opinion on the true and fair view of the organization’s financial position. There are three remarkable institutions and standard setters in Islamic finance (Accounting and Auditing Organisation for Islamic Financial Institutions, Islamic Financial Services Board, and Bank Negara Malaysia) have attempts to put in place the Shariah audit framework in organized way and extensive details. Here we will discuss in detail the three institutions in terms of the background, definitions and related operationalization of Shariah governance and audit. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), established in 2006 has the objective to maintain and promote Shariah standards for Islamic financial institutions, participants and the overall industry. For that, it ensures the participants in the IFIs conform to the regulations set out in Islamic finance. The founding and associate members, as well as the regulatory and supervisory authorities of the AAOIFI, define the acceptable standards for various functions. Up to now, AAOIFI produced Shariah, accounting, governance, ethics and audit standards. 3
4. Table 1 : Shariah Audit Definition, Responsibilities, Scopes and Reporting Prescribed by BNM, IFSB and AAOIFI BNM ITEMS (Bank Negara Malaysia) IFSB AAOIFI (Islamic Financial (Accounting and Auditing Services Board) Organisation For Islamic Financial Institutions)  Periodical assessment to provide independent assessment and objective assurance to add value and improve IFIs compliance in ensuring sound and effective internal control system for Shariah compliance.  Internal Shariah Review/ Audit Unit (ISRU) to verify Shariah compliance has been satisfied.  Expression of opinion on financial statement that need to be prepared in all material respects, in accordance with the fatwas, rulings and guidelines issued by the SSB, accounting standards of the AAOIFI, national accounting standard and practices, and relevant legislation and regulations applied in the country. provide Responsibility  To independent assessment and objective assurance to add value and improve IFIs compliance in ensuring sound and effective internal control system for Shariah compliance includes: a. Assess efficiency and effectiveness of internal control system; b. Assess compliance to guidelines set by regulator; and c. Assess compliance to internal policies & procedures.  Develop  Record and report any incident of any noncompliance.  Address and rectify any noncompliance activity.  Shall require or recommend the management to address and rectify any issues of Shariah compliance.  Review of Internal Controls (including internal audit).  Review of accounting practices and audit plan.  Review of interim and annual accounts and financial reports (inclusive of matters arising from the audit).  Ensure IFIs adheres to AAOIFIs’ Code of Ethics for Accountants and Auditors of IFIs.  Review the compliance with Shariah rules and principles.  Review the use of restricted investment accounts’ funds.  To assist the BOD in exercising independent and objective monitoring as follows: a. Preserving the integrity of financial Definition 4
5. BNM (Bank Negara ITEMS Malaysia) -    IFSB AAOIFI (Islamic Financial (Accounting and Auditing Services Board) Organisation For Islamic Financial Institutions) comprehensive internal audit program or plan: Objective, scope, personnel assignment, sampling, control & duration Establish proper audit processes. Obtain and make reference to relevant references – Shariah Advisory Council rulings, Shariah Committee decision, fatwas, guidelines, Shariah audit results & internal Shariah checklist. Provide recommendations & follow up on rectification measures taken by IFIs. To be performed by internal auditors, who have acquired Shariah related knowledge and training. The internal auditors may engage expertise of Shariah officers in performing the audit. reporting process. b. Safeguarding the interests of shareholders, investors, and other corporate stakeholders. c. Providing additional assurance on the reliability of financial information presented to the BOD. d. Acting as an independent link between the IFIs’ management and its stakeholders. 5
6. BNM ITEMS (Bank Negara Malaysia) IFSB AAOIFI (Islamic Financial (Accounting and Auditing Services Board) Organisation For Islamic Financial Institutions) Scope  Audit of financial statement of IFIs.  Compliance audit on organizational structure, people and information technology application system.  Review adequacy of Shariah governance process. ISRU will review the products and services and see if it adhered to the opinions of Shariah board.  The subject matter of Shariah Audit not only cover the financial statement but also akhlaq (ethics), internal processes, personnel, financial and nonfinancial performance, financial position, information and IT systems, marketing and other relevant issues pertaining to Shariah. Reporting  Shariah Audit findings shall be reported to the Board of Committee and Shariah Committee. ISRU shall report to the Shariah board. Produce reports indicating whether the IIFS has complied with Shariah requirements throughout the financial year. Where appropriate, the ISRU reports shall require or recommend the management of the IIFS to address and rectify any issues of Shariah compliance.  Shariah audit will provide additional assurance on the reliability of financial information presented to the Board of Director.  Audit report reflects the opinion of the auditor on the audited financial statements and on the IFI’s accounting and other records. Source: SGF (2010), IFSB (2009) and AAOIFI (2010) 6
7. As highlighted in Table 1 , according to AAOIFI’s Auditing Standard for Islamic Financial Institutions No. 1 (ASIFI 1), the objective of audit is to enable the auditor to express an opinion that the financial statement are prepared in all material respects, in accordance with the fatwas, rulings and guidelines issued by the Shariah Supervisory board of the Islamic financial Institutions, AAOIFI accounting standards, national accounting standards and practices, and relevant legislation and regulations applied in the country in which the Islamic Financial institution operates. Referring to the definition provided by AAOIFI, the standard refers audit as an expression of opinion on the financial statement whereas the scope should be expanded to cover the overall activities and operations of the IFIs that in accordance with Shariah rulings of a country. The subject matter of the Shariah audit should be wider than a financial statement audit. In line with the broader scope of the Shariah including akhlaq (ethics) not only should the financial statements, but the IFIs internal processes, personnel, financial and non-financial performance, financial position, information and IT systems, marketing of the IFI’s product and other relevant issues pertaining to Shariah. ASIFI 1 quotes that the audit conducted should adhere to Shariah principles, AAOIFI and other relevant accounting standards and practices in the country which the IFIs operate. However, there is argument that the necessity to comply with two sets of criteria (AAOIFI and national) might lead to conflicts because when national jurisdiction requires banks to follow International Financial Reporting Standards, then IFRS does not allow mutual existence and tolerance of other standards. At current, among countries that adopt AAOIFI standards as part of their regulatory framework for IFIs are the GCC countries, Sudan and Jordan. In Malaysia, Shariah Governance Framework (SGF) issued by Bank Negara Malaysia (BNM) in 2010 addressed the implementation of Shariah audit function in IFIs. The SGF is a set of organizational arrangements through which IFIs ensure effective oversight, responsibility and accountability of the Board of Directors, management and Shariah Committee. The framework serves as a guide towards ensuring an operating environment that is compliant with Shariah principles at all times. In measuring the IFIs compliance to the Shariah, SGF requires regular internal Shariah reviews and Shariah audit, supported by an appropriate risk management process and research capability. International Shariah scholars and bankers believe that given the 7
8. systemic approach of Malaysia in developing its Islamic finance sector , the SGF is the best of its kind and could become a blueprint for other countries to follow. Furthermore, recent issuance of Islamic Financial Services Act (IFSA) in Malaysia outlines the more stringent and detailed requirement especially towards the Shariah governance function and duties of the Board of Directors, senior officers and members of the Shariah Committee. It is interesting to note that any person mentioned, who fails to comply with any standard issued by Bank Negara Malaysia, or commit an offence, upon conviction, shall be liable to imprisonment for a term not exceeding eight years or to a fine not exceeding twenty-five million ringgits or both (Section 29 (6), IFSA 2013) Table 1 also summarises the Shariah audit definition provided in Paragraph 7.7 of SGF (2010) that states that ‘Shariah audit refers to the periodical assessment conducted from time to time, to provide an independent assessment and objective assurance designed to add value and improve the degree of compliance in relation to the IFI’s business operations, with the main objective of ensuring a sound and effective internal control system for Shariah compliance’. Given the statement above, it can be concluded that Shariah audit can best be defined as a process of accumulating and evaluating evidence that relates to the overall activities and operations (process, personnel, financial and non-financial performance, financial position, systems, marketing, etc.) of the IFIs in which the information gathered must be in adherence to the Shariah principles. Shariah audit in the IFIs shall be performed by independent auditors who are also competent in addressing Shariah matters. In term of scope, SGF by Bank Negara Malaysia (2010) explains that Shariah audit would covers all aspects of the IFI’s business operations and activities, including: i. Audit of financial statements of the IFI; ii. Compliance audit on organisational structure, people, process and information technology application systems; and iii. Review of adequacy of the Shariah governance process. SGF further extended that the scope of the internal Shariah audit shall include any area which involves Shariah compliance issues such as products and services, Shariah review function, financial reporting, Shariah governance practices, organizational structure, human resources (people), processes, marketing and information system. In addition, SGF also suggested that the Shariah audit may be conducted as part of the 8
9. IFI ’s thematic audit on specialized areas such as management audit and Anti-Money Laundering (AML) audit. Shariah audit on critical areas shall be conducted. The function of shariah audit should be performed by internal auditors, who have acquired adequate Shariah-related knowledge and training. In addition, the internal auditors may engage the expertise of the IFI’s Shariah officers in performing the audit, as long as the objectivity of the audit is not compromised. Shariah audit in the IFI shall be conducted at least on an annual basis, verifying that the IFI’s key functions and business operations comply with Shariah. Figure 2 features the Shariah Governance Framework that should be established in every Islamic Financial Institutions (IFIs) in Malaysia. Figure 1: Shariah Compliance Framework for Islamic Financial Institutions Source: Shariah Governance Framework (BNM, 2010) 2.2 Shariah Audit Practices in GCC, Sudan, Pakistan, Indonesia, and Malaysia As regulators in GCC adopt minimalist approach to Shariah governance (Hasan, 2010), the review of Shariah governance and assurance practices will provided the way of financial and non-financial reports of leading Islamic banks in each country in 9
10. GCC . In addition, the paper examines the regulatory requirements and guidelines by the regulators in in countries where Islamic finance is adopted as part of the mainstream finance, i.e. Sudan, Pakistan, Indonesia and Malaysia. 2.2.1 Shariah Audit Practices in GCC Countries The majority of the IFIs in GCC countries have developed their own Shariah guidelines and standard processes on Shariah compliance. From the examinations of the financial and non-financial statements of leading Islamic banks in each of GCC, it was found that most of the banks in GCC countries conducted Shariah review rather than Shariah audit. Shariah review in the Islamic banks in GCC is conducted by the Shariah Supervisory Board (SSB) of the IFIs. However, in terms of auditing, only minimal percentage of IFIs’ Shariah Supervisory Board in Islamic banks in GCC indicated that the functions had been delegated to internal Shariah compliance unit. Table 2 provides the summary of the framework of Shariah assurance in GCC. Table 2: Shariah Compliance Framework among GCC countries IFIs, Regulatory Islamic Country Authority Banking Law Bahrain Central Bank of Bahrain Not disclosed Shariah Committee At Central At Bank Bank Level Shariah Shariah Supervisory Supervisor Committee y Board Shariah Acct. Standard Standard AAOIFI AAOIFI Saudi Arabian Saudi Arabia Monetary Agency (SAMA) & Capital Market Authority Banking Control Law Shariah Supervisory Board Shariah Not Authority Disclosed IFRS (CMA) Kuwait Qatar UAE Central Bank of Kuwait Qatar Central Bank UAE Central Bank Commercial Shariah Shariah Companies Supervisory Supervisor 1960 Board y Board Shariah Shariah Supervisory Supervisor Board y Board Commercial Shariah Shariah Companies Supervisory Supervisor 1984 Board y Board Not Disclosed 10 AAOIFI IFRS AAOIFI IFRS Not Disclosed IFRS
11. IFIs in GCC disclosed significant findings in its Shariah Supervisory Report that includes the results of Shariah review . This effort shows that the IFIs in the GCC countries promote transparency in Shariah compliance aspects. As reported in Table 2, the examination into the annual reports of Bahrain Islamic Bank (BISB) found that the SSB in BISB acts as monitoring function included the checking of documents and procedures to scrutinize each operation carried out by the Bank, whether directly or through the Shariah Internal Audit department. The SSB of BISB planned with the Shariah Internal Audit department to carry out monitoring functions by obtaining all the information and clarifications that were deemed necessary to confirm that the Bank did not violate the principles and provisions of Islamic Shariah. The Shariah Internal Audit department in BISB audited the Bank’s transactions and submitted a report to the SSB. The report confirmed the Bank’s commitment and conformity to the SSB’s opinions. Al-Rajhi Bank in Saudi Arabia established an independent Shariah Board, formed and ratified by the Constituent General Assembly with the objective of ensuring that all Bank activities are subject to the approval of the Shariah Board. The Juristic Control Department is responsible for exercising the necessary controls and reports directly to the Shariah Board. The Juristic Control Department is responsible for supervising the activities of the Bank in terms of verifying the implementation of the Shariah Board’s decisions. In 2011, over 300 visits were made to branches, transfer centres, and trading rooms and training sessions were conducted for 340 new employees with 15 courses held. However, in Al-Rajhi’s annual report 2011, the Shariah Supervisory Board report was not being disclosed to the public. In Kuwait Finance House, through the Shariah Supervisory, review has been conducted on a random basis on samples of operation which provided returns to all transactions of KFH with shareholders, investors and others. This is based on the annual Shariah audit plan on all departments, periodic reports submitted by Shariah Supervisory Department regarding the auditing operations, field visits and on the operation and the correct implementation of fatwa and resolutions issued by the Shariah Board. 11
12. The practice held in Qatar Islamic bank through its Executive Committee and Shariah Audit Department , the Shariah Supervisory Board has directly supervised the Bank’s activities and are satisfied that its resolutions have been righteously executed. The Shariah Supervisory Board confirms that the responsibility for applying the Shariah norms and controls lies mainly on the Bank’s Management, as the Shariah Supervisory Board’s liability is confined to giving relevant jurisdictions (fatwas) and reviewing the transactions referred to it, whether they were addressed to it directly or through the Shariah Audit Department as implied by the authorities vested in the Shariah Audit Department. In addition, Qatar Islamic bank played an equally important role in developing AAOIFI standards working closely with the Accounting and Auditing Standards Council for Islamic Financial Institutions. Finally, Dubai Islamic Bank’s annual report was limited to the financial reports only. Thus, information on Shariah governance and audit in Dubai Islamic bank were very limited and this information was obtained from the website and other resources. 2.2.2 Shariah Audit Practices in Sudan The Central Bank of Sudan was established in 1959 to undertake the functions of the Central Bank stipulated in the Bank of Sudan Act. These functions included oversight and supervision of the banking system and its development and promotion, issuance and management of the national currency, management of the exchange rate, maintaining stability of the economy and other functions carried out by the central banks as a primary body contributing in the economic turnover of the economic wheel in the country. There are two unique and important characteristics associated with Sudanese Banking System, namely, it’s the first banking system in the world based on the rules of Shariah which prohibit interest rates. Since 1983 Sudan had adopted a purely Islamic banking system from the signing of the Comprehensive Peace Agreement (CPA) between Sudanese Government and the Sudanese People's Liberation Movement in 2005, according to the CPA the south was exempted from conducting an Islamic system and instead to operate a conventional system. Sudan Central Bank operates within two systems: Islamic in the North and conventional in the South, which represent the second characteristic of Sudanese banking system, the feature of conducting a single monetary policy governing two banking systems. 12
13. In Sudan , the term Shariah audit is not being mentioned, neither in the annual report of the Islamic Bank nor the website of central bank of Sudan. However, they conducted Shariah review as a commitment to show their responsibility in determining Shariah compliance in the Islamic Bank1. However, the Shariah Supervisory report in the annual report of its Islamic Bank did not thoroughly disclosed on the findings of Shariah Review. At current, there is no disclosure on the Shariah non-compliance activities arise in the Islamic Bank in Sudan. 2.2.3 Shariah Audit Practices in Pakistan The Islamic banking movement in Pakistan was a nationwide and comprehensive. As it was a mammoth task, the switch-over plan was implemented in phases. The process was started by transforming the operations of specialized financial institutions like National Investment Trust (NIT), Investment Corporation of Pakistan (ICP), and House Building Finance Corporation (HBFC) to the system conforming to the Islamic principles with effect from July 1, 1979. Separate Interest-free counters started operating in all the nationalized commercial banks, and one foreign bank from January 1, 1981, to mobilize deposits on profit and loss sharing basis. As from July 1, 1985, all commercial banking operations were made ‘interest-free’. From that date, no bank in Pakistan, including foreign banks, was allowed to accept any interest-bearing deposits. All existing deposits in banks were treated to be on the basis of profit and loss sharing. However, foreign currency deposits/loans were continued to govern on interest basis. The government meanwhile also passed Mudarabah Companies Act 1984, enabled financial institutions or business groups to setup special Mudaraba Companies in a country2. The regulatory authority related to Islamic banking in Pakistan is the State Bank of Pakistan. The State Bank of Pakistan (SBP) has established a dedicated Islamic Banking Department (IBD) that operates in close coordination with Policy and Regulatory Department and Inspection and Supervision departments to facilitate IFIs development. The IBD coordinates with rest of the SBP and banking industry to provide valuable regulatory guidance related to overall Shariah Compliance and specific issues/challenges being faced by the Islamic banks in Pakistan3. 1 Sources from annual report of Faisal Islamic Bank Sudan retrieved at http://www.fibsudan.com State Bank of Pakistan website. Available online at http://www.sbp.org.pk 3 Keynote address delivered at Annual Corporate Governance Conference Dubai on November 27, 2006 by Dr. Shamsad Akhtar, the Governor of State Bank of Pakistan on ‘Shariah Compliant Corporate Governance’. 2 13
14. SBP has put into place a comprehensive and robust multi-tiered Shariah compliance mechanism to lend customers and investors ’ confidence in the Islamic banking industry. Shariah compliance mechanism has three main pillars: (i) a Shariah Board at SBP which approves policies and guidelines as well as the fit and proper criteria for Advisors; (ii) Shariah Advisors in all banks to provide guidance to banks and comfort to customers on Islamic financial services; and (iii) a Shariah audit system. Shariah Audit System is develop based on the inspection manual, which is very comprehensive, was compiled by Ernst & Young out of Bahrain in collaboration with their affiliate in Pakistan. The Shariah Audit system is needed to ensure that specific terms of Islamic contracts, fatwa on the transaction, as well as the sequence of execution of the agreement are conducted according to Shariah principles. The preparations of the financial statements in are based on AAOIFI standards and the inspection is geared towards auditing the transactions according to these standards. In addition to the normal SBP inspection, all banks conducting Islamic banking will also have to undergo the Shariah Compliance Inspection. Shariah compliance inspection of Islamic banks covers a review of the Islamic banks’ arrangements and operations, their services and products, financial statements and accounting records to ensure that all transactions are being carried out in accordance with the injunctions of Shariah. In order to strengthen the Shariah compliance mechanism in Islamic Banking, the SBP ensure that all relevant Islamic banking regulations are complied with in letter and spirit and shall be adherence to the Shariah Compliance framework. The Shariah Compliance framework in Pakistan specifically emphasis on Shariah aspects with relevant provisions of existing laws, rules, regulations, policies and procedures related to Islamic Banking. The laws and provisions need to be embedded in the IFI’s processes in such a manner that monitoring and reviewing of issues related to Shariah compliance forms part of internal control structure. Monitoring and reviewing for Shariah Compliance should cover all activities, products and locations of the IFI. The basic purpose of this responsibility is to ascertain whether the transactions, processes and products undertaken by the IFI are Shariah compliant and all related conditions are being met, as approved by Shariah Advisor. 14
15. In terms of auditing , the IFIs in Pakistan introduce a system of internal Shariah audit, so as to ensure that the goals and objectives of Shariah compliance are achieved. Internal Shariah Audit of IFIs is part of the regular internal audit or as a separate unit depending upon size of operations of the IFI. The primary objective of the Internal Shariah Audit is to ensure that the management of the IFI is discharging its responsibilities in compliance with Shariah rules and principles as prescribed by SBP and the Shariah Advisor of the IFI. The purpose of the Internal Shariah Audit is to ensure that the system of internal control for Shariah Compliance is conceptually sound and effective in implementation, so as to ensure that the goals and objectives for Shariah compliance are achieved. The Internal Shariah Audit is carried out in conformity with Shariah rules and principles, guidelines and instructions issued by SBP. The internal Shariah auditors have direct and regular communications with all levels of management and Shariah Advisor. There is no scope limitation and restriction of access to information, documents, reports and etc. In terms of reporting, the report of Internal Shariah Audit contains observations and assessment of systems and controls in place for Shariah compliance. The Internal Shariah Audit report will also include recommendations for potential improvements and corrective actions to be taken. Any disputes or differences of opinion between management and Internal Shariah auditors on matters relating to Shariah interpretation is referred to the Shariah Advisor of the IFI for decision. The report of the Internal Shariah Audit is tabled before the Shariah Advisors for advising the appropriate corrective action and then before the Audit Committee of the IFI for consideration and appropriate remedial action as advised by the Shariah Advisors. The report from Shariah audit findings are extensively highlighted in the IFIs of Pakistan through the Shariah Supervisory report. In the audit process areas covered in Shariah auditing are as follows:  Agreements for Murabaha, Ijarah, Diminishing Musharakah, Istisna, Tijarah and Bai Salam;  Declaration, description of Assets, relevant purchase invoices, sequence and order of the documents and time differences between purchases and declaration in Murabaha;  Murabaha monitoring Sheets and delayed Declaration reports; 15
16.  Ownership ratio in Diminishing Musharakah for Housing and issuance of timely unit sale receipts;  Investment made in stock with reference to the stock screening criteria;  Import Finance transactions and related documentations;  Extensive reviews of client payment, purchase cycle and periodic assessment of client’s processes;  Other related documents and procedures followed by different functional areas; and  Profit-sharing ratio, profit weightage, pool working, asset & deposit allocation for deposit products. SBP instructed all IFIs to dedicate few members of IFIs’ Internal Audit Department for Shariah Audit or create a separate Shariah Internal Audit Department, depending upon the size of the bank. The main responsibility lies with this department for Shariah Audit. There are some areas like PLS profit distribution, where SBP instructed banks to audit the whole process jointly from Shariah Advisor (SA) and external auditors. Thus, one can say that in Pakistan, Shariah Audit is done by both internal and external Auditors. In addition, the external auditor report in Islamic Banking in Pakistan did not mentioned on Shariah audit findings. The rationale behind this is that Islamic Banking is at nurturing stage, and any such type of Shariah observations will not only hurt the bank but also hurt the perception of Islamic Banking Industry. Thus, it is not enforced by the law to mention Shariah findings in the report. Further, if Shariah observations are found by internal or external auditors, then they highlight these to SA to take action, what he deems fit. Furthermore, SBP Banking Inspection team also inspects Shariah Compliance of the bank and if any observations, highlighted to SA, and impose penal action. 2.2.4 Shariah Audit Practices in Indonesia The development of modern Islamic banking in Indonesia was formally initiated in 1991, in line with the enactment of Banking Act No. 7 of 1992 which includes provisions to develop interest-free banking. Indonesia's first Islamic bank was Bank Muamalat, which was established in 1991. It operates according to the tenets of Shariah law, which prohibits charging interest on loans and paying interest on deposits. Based on the Banking Act No. 7 of 1992, Indonesia recognized the existence 16
17. of a dual banking system , that is, a system where conventional banking grows side by-side with Islamic banking to serve the economy. On 25 June 2003, an agreement was signed between Bank Indonesia and The Indonesian Institute of Accountants (IAI) to structure the accounting standard for Islamic banks (including the implementation of research and training cooperation for the field that relates to the competency of IAI). Since 2001, Audit Guideline for Islamic banks, Review on Guideline of Financial Accounting Standard (PSAK) 59 and Financial Accounting Standard for Islamic Bank in Indonesia (PAPSI) have been issued by IAI. In drafting the Shariah financial accounting standards, IAI works with Bank Indonesia, National Shariah Board and Shariah banking practitioners. Standards released by the International Shariah financial accounting body such as AAOIFI are used as a benchmark. Islamic Banking in Indonesia conducted Shariah review. Shariah audit work is reported to be conducted in Indonesia’s Islamic Banks. Shariah review are conducted by the Shariah Committee of the IFIs and been declared in the annual report. The findings arise from Shariah review conducted, was not been disclosed in the annual report4. 2.2.5 Shariah Audit Practices in Malaysia The Islamic financial system in Malaysia was first introduced in 1963. At current, Malaysia has 17 full-fledged Islamic financial Institutions operating parallel to conventional financial system. Shariah Governance Framework (BNM, 2010) issued by the Central Bank of Malaysia has enlightened the practice of Shariah governance in ensuring Shariah assurance in the IFIs. International Shariah scholars and bankers believe that given the systemic approach of Malaysia in developing its Islamic finance sector, the SGF is the best of its kind and could become a blueprint for other countries to follow. Previously, the practice of Shariah audit in IFIs in Malaysia is on voluntary basis. The practice of Shariah audit in Malaysia is limited to Shariah compliance of the products only. This is because Shariah Committee of the IFIs normally expressed their opinions on the Shariah compliance of the products and services offered (ex-ante compliance). At current, a comprehensive and well-guided audit of the Shariah legal contracts, documentations and operations so far has not been properly conducted. The 4 Sources from annual report of Bank Shariah Mandiri, Indonesia 17
18. ex-post compliance stage is absence in the practise . However, since Bank Negara Malaysia has launched its new Shariah Governance Framework by the end of June 2011 each IFI authorized and operating in Malaysia is required to confirm the status of compliance with the Framework, which was adopted pursuant to section 59 of the Central Bank of Malaysia Act 2009, section 53A of the Islamic Banking Act (IBA), section 69 of the Takaful Act (TA), section 126 of the Banking & Financial Institutions Act (BAFIA) and section 126 of the Development Finance Institutions Act (DFIA). This shows that all IFIs in Malaysia need to consider the seriousness in implementing Shariah audit in the institutions. Many Islamic Banks in Malaysia attached Shariah audit function to the internal audit department. Shariah audit function is one of the internal audit function in performing check and balances in the IFIs. Shariah audit function is led by Shariah audit manager which assist the Chief Internal Auditors (CIA) in establishment of the scope of Shariah audit work, organize and manage the audit to achieve the audit plans and activities. Shariah audit function in IFIs also review the risk assessment of Shariah compliance audit and ensure the audit program comprehensively covers the area of audit work. Shariah audit manager of an IFI is also responsible to provide guidance and consultation on Shariah compliance to internal auditors in the department. At the end of auditing process, Shariah audit manager of an IFI shall draft the audit report on Shariah audit findings and submit to the CIA. In addition, Shariah audit manager is also responsible to updates on Shariah matters in respect to BNM guidelines and regulatory requirements. III. Methodology This research uses the content analysis method analyzing five years of annual report of five Islamic banks from each of GCC countries. The annual report was retrieved in the Islamic banks website. The selection of the Islamic banks from each of the GCC countries was based on their excellent track record in the industry. The Islamic banks studied in this research were Al Rajhi (Saudi Arabia), Dubai Islamic Bank (UAE), Kuwait Finance House (Kuwait), Masraf Al Rayan (Qatar), Baraka Islamic Bank (Kingdom of Bahrain) and Alizz bank (Oman). To ensure that the Shariah governance and audit in the Islamic banks were in place, this study proposed Shariah Auditing Disclosure Index (SADI) to compare and contrast the Shariah audit practices among the Islamic Banks in GCC countries. Shariah Auditing Disclosure Index (SADI) was derived from the AAOIFI standards on Governance Standard for Islamic Financial 18
19. Institutions (GSIFI) and Auditing Standard for Islamic Financial Institutions (ASIFI). The AAOIFI standards were used as the benchmark since it is widely used in the GCC countries. The analysis of the banks consists of 5 years analysis from 2011 till 2015. Based on the analysis this research is able to develop the evolution of Shariah governance and audit disclosure for 5 consecutive years. IV. Analysis and Discussion The analysis of the banks consists for 5 years analysis from 2011 till 2015 are performed on seven shariah governance and assurance practices5 namely the existence of Shariah Supervisory Board (SSB) Report and the scope and responsibility of the SSB, the aspects of opinion of SSB Report such as transaction and activities, zakat, computation of profit and loss and Shariah non-compliant income. In addition, the Shariah assurance practice namely Shariah review and audit is also analysed for the each of banks under analysis for the five years. Table 3 summarizes the analysis. Based on Table 3 below most of the Islamic banks consistently disclose information on scope, responsibility, Shariah opinion and existence of SSB report except for Dubai Islamic banks. This is because in 2011 and 2012 Dubai Islamic bank scores ‘1’ that shows its commitment in reporting all the important requirement. However, starting 2013 the score for Dubai Islamic bank started to decrease since it does not disclose certain criteria in the annual report. The score drops to 0.57 from 2013 and above. Unlike Alizz bank in Oman, there is no disclosure in 2011 and 2012 since the banks just enter into operations in 2013. However, Alizz bank in Oman shows excellent record along with Al-Baraka Islamic Bank in Bahrain6. 5 The seven shariah governance and assurance practices are based on the best practices of GCC and other benchmarking countries such as Malaysia and Pakistan 6 The detail analysis is available in the appendix section 19
20. Table 3 : Shariah governance and audit disclosure Index in the annual report ISLAMIC BANKS 2015 Al Rajhi 3/7 Bank (0.43) (KSA) Dubai 4/7 Islamic Bank (0.57) (UAE) Masraf Al 4/7 Rayan (0.57) (Qatar) Al Baraka Islamic Bank 7/7 (Kingdom of (1.00) Bahrain) KFH 6/7 (Kwait) (0.85) Alizz bank 7/7 (Oman) (1.00) *ND = Non-disclosure 2014 YEAR 2013 2012 2011 3/7 (0.43) 3/7 (0.43) 3/7 (0.43) 3/7 (0.43) 4/7 (0.57) 4/7 (0.57) 7/7 (1.00) 7/7 (1.00) 4/7 (0.57) 4/7 (0.57) 4/7 (0.57) 4/7 (0.57) 7/7 (1.00) 7/7 (1.00) 7/7 (1.00) 7/7 (1.00) 6/7 (0.85) 7/7 (1.00) 6/7 (0.85) 7/7 (1.00) 6/7 (0.85) 6/7 (0.85) ND ND Table 4 provides detailed analysis of the governance and assurance mechanisms adopted in each of the banks in 20 the GCC under the analysis.
21. Table 4 : Shariah Governance and Assurance Mechanisms in GCC as Disclosed in Annual Reports for the year 2011 to 2015 NonShariah compliance Revenue Computatio n of Profit & loss Zakat Transaction s& activities Responsibility Scope Existence of SSB’s Report Bank Opinion Shariah Review & Audit Total score YEAR 2016 Al Rajhi Bank (KSA) Dubai Islamic Bank (UAE) Masraf Al Rayan (Qatar) Al Baraka Islamic Bank (Kingdom of Bahrain) KFH (Kwait) Alizz bank (Oman) √ √ √ √ √ √ √ √ √ 0 √ √ √ √ √ √ √ √ √ √ √ 0 √ 7/7 YEAR 2015 Al Rajhi Bank (KSA) Dubai Islamic Bank (UAE) Masraf Al Rayan (Qatar) Al Baraka Islamic Bank (Kingdom of Bahrain) KFH (Kwait) - - 0 0 √ √ √ 0 0 0 0 √ √ √ √ No clear distinguish between Shariah review & audit 0 0 √ √ √ 0 √ 0 √ √ √ √ √ √ √ There is distinguishing between Shariah review & audit in the annual SSB’s report √ √ 0 √ √ √ √ 0 21 3/7 (0.43) 4/7 (0.57) 4/7 (0.57) 7/7 (1.00) 6/7 (0.85)
22. Alizz bank (Oman) √ √ √ √ √ √ There is distinguishing between Shariah review & audit in the CG but not in the annual report √ 7/7 (1.00) YEAR 2014 Al Rajhi Bank (KSA) Dubai Islamic Bank (UAE) Masraf Al Rayan (Qatar) Baraka Islamic Bank (Kingdom of Bahrain) KFH (Kwait) Alizz bank (Oman) - 0 0 √ √ √ 0 0 0 0 0 √ √ √ √ No clear distinguish between Shariah review & audit 0 0 √ √ √ 0 √ 0 √ √ √ √ √ √ √ √ √ 0 √ √ √ √ √ √ √ √ √ √ √ There is distinguishing between Shariah review & audit in the annual SSB’s report There is distinguishing between Shariah review & audit in the annual SSB’s report There is distinguishing between Shariah review & audit in the CG but not in the annual report 3/7 (0.43) 4/7 (0.57) 4/7 (0.57) 7/7 (1.00) 6/7 (0.85) 7/7 (1.00) YEAR 2013 Al Rajhi Bank (KSA) Dubai Islamic Bank (UAE) Masraf Al Rayan (Qatar) Al Baraka Islamic Bank (Kingdom of Bahrain) KFH (Kwait) Alizz bank (Oman) - 0 0 √ √ √ 0 0 0 0 0 √ √ √ √ No clear distinguish between Shariah review & audit 0 0 √ √ √ 0 √ 0 √ √ √ √ √ √ √ √ √ 0 √ √ √ √ √ √ √ √ √ √ √ There is distinguishing between Shariah review & audit in the annual SSB’s report There is distinguishing between Shariah review & audit in the annual SSB’s report There is distinguishing between Shariah review & audit in the CG but not in the annual report 3/7 (0.43) 4/7 (0.57) 4/7 (0.57) 7/7 (1.00) 6/7 (0.85) 7/7 (1.00) YEAR 2012 Al Rajhi Bank (KSA) - 0 0 √ √ √ 0 22 3/7 (0.43)
23. Dubai Islamic Bank (UAE) Masraf Al Rayan (Qatar) Al Baraka Islamic Bank (Kingdom of Bahrain) KFH (Kwait) Alizz bank (Oman) √ √ √ √ √ √ √ No clear distinguish between Shariah review & audit 0 0 √ √ √ 0 √ 0 √ √ √ √ √ √ √ √ √ 0 √ √ √ √ There is distinguishing between Shariah review & audit in the annual SSB’s report There is distinguishing between Shariah review & audit in the annual SSB’s report 7/7 (1.00) 4/7 (0.57) 7/7 (1.00) 6/7 (0.85) N N N N N N N N N YEAR 2011 Al Rajhi Bank (KSA) Dubai Islamic Bank (UAE) Masraf Al Rayan (Qatar) Al Baraka Islamic Bank (Kingdom of Bahrain) KFH (Kuwait) Alizz bank(Oman) - 0 0 √ √ √ 0 0 √ √ √ √ √ √ √ No clear distinguish between Shariah review & audit 0 0 √ √ √ 0 √ 0 √ √ √ √ √ √ √ √ √ 0 √ √ √ √ There is distinguishing between Shariah review & audit in the annual SSB’s report There is distinguishing between Shariah review & audit in the annual SSB’s report N N N N N N N N 0 = No disclosure √ = Disclose in the annual report 23 3/7 (0.43) 7/7 (1.00) 4/7 (0.57) 7/7 (1.00) 6/7 (0.85) N
24. In addition to the indexing exercise , further information on the Shariah assurance practices reported in the annual reports of the banks in the GCC are analysed qualitatively. The summary of the findings is reported in Table 5. Table 5: Qualitative Content of Shariah Governance and Assurance in Annual Reports in GCC for the Year 2011 to 2015 Islamic Banks in Shariah Governance and Assurance Reporting Content GCC 1. Alrajhi Bank, KSA - 2. Dubai Islamic Bank, UAE - 3. Masraf Al Rayan, Qatar - - There is no specific SSB report. No standard in reporting the SSB’s related information along the 5 years. Statement of the establishment of Shariah Authority in the annual report of 2011, 2013, and 2014, there is statement of as body to review and approve all activities of the bank with relation to shariah compliance. Some corporate information about SSB and its sub-departments been mentioned in summary of activities section, however, this section is not included in 2012 and 2014 annual reports. It is noted that the corporate information varied from year to another. The SSB involved in Zakat calculated and paid in accordance with the instructions of the bank’s Sharia Board. The responsibility and scope of SSB been mentioned in the SSB policies, but not in the annual reports There is no mentioning for the any departments or bodies conducting Shariah auditing and review. There is no distinguishing between Shariah review & audit. Fatwa & Sharia Supervision Board is the used name as SSB. The Board has studied all transactions referred to it. (this statement shows that the SSB only review what they received only). SSB’s annual report only for 2011 and 2012. For the 2013, 2014, and 2015 there is no specific part in the annual report for SSB’s report. Although, in the code of corporate governance of DIB stating that SSB shall report annually to the shareholders, but not for the years 2013, 2014, and 2015. All the SSB’s discussion and issues been included in notes to the account, under significant accounting policies. AAOIFI is adopted in Masraf AlRayan. Although, in the code of corporate governance of Masraf AlRayan stating that SSB shall report annually to the shareholders, however there is no specific part in the annual report for SSB’s report. There is no mentioning for the any departments or bodies conducting Shariah auditing and review. There is no distinguishing between Shariah review & audit. 24
25. 4 . Aizz Bank, Oman - The Board has studied all transactions referred to it, but not all. - There is specific SSB report. The bank provides a Fatwa certificate with each product or service offered, which is signed by the SSB. The General Assembly appoints the SSB based on the Board of Directors nomination. SSB must consist of not less than three members. The Shari'a Audit and Compliance Department will prepare reports for SSB to review concerning the audit of the bank's transactions and to which extent such transactions are compliant with the provisions of Islamic Shari'a and the fatwas and resolutions of the Board. Developing a satisfactory mechanism for an annual check of SSB members for independence and conflict of interest. The Board shall also carry out an annual assessment of the SSB members (including attendance of Shari'a board meetings, among other criteria) and submit the assessment report to the Central Bank. The SSB’s report of 2015 is more comprehensive compare the reports of 2013 and 2014, including corporate information about the number of meetings and other communication through other tools. In the annual report the bank provides short C.V about the SSB’s members. - - - - 5. KFH Bank, Kuwait - - There is specific SSB report. The General Assembly appoints the SSB based on the Board of Directors nomination. SSB must consist of not less than five members. Determine 12 meeting annually to be conducted minimum. Stated the qualifications of SSB members to be qualified and experience in Fiqh Muamalat and Islamic banking. Statement of “The Shariah Audit has been conducted on” been used. It is stated in the SSB’s annual report that randomly selected samples of all financing operations of KFH with the shareholders, investors and others in accordance with the Annual Shariah Audit plan for all Departments been used. In Year 2013, the disclosure level in the SSB’s report is improved compared to 2011 and 2012. In Year 2013 start to state the number of meetings. The Shariah Control and Advisory Department is doing the review. In the 2013 SSB’s report, there is more detail in review process compare to the previous years, however year 2014 and 2015 is less details. In the annual report the bank provides short C.V about the SSB’s 25
26. - 6 . Al Baraka Bank, Bahrain - V. members. The responsibility statement in the SSB’s annual report is explicit and indirect. There is specific SSB annual report. The annual SSB’s report is well organized. Using the term supervised in the SSB’s report along the four years till year 2015 been changes to be reviewed. The name of SSB’s in year 2015 been change to Unified Shari’a Supervisory Board report. In Year 2015, the disclosure level in the SSB’s report is improved compared to prior years. In Year 2015 start to state the number of meetings of SSB’s members. In the 2015 SSB’s report, there is more detail in review process compare to the previous years. Conclusion It is the requirements of an IFI to carry out their activities in accordance with the principles of Shariah. However, the governance and Shariah assurance practices in GCC are found to be inconsistent and non-standardised. Thus, it is imperative to have well planned and executed Shariah audit function within IFIs in order to promote transparency and comparability of Shariah governance and assurance mechanisms in these jurisdictions. In this regard, it is essential to have a comprehensive, robust and well-functioning Shariah control system to ensure that Shariah is upheld at all times. The limitation of the research paper is that the analyses conducted were limited to the disclosures in the annual report and website of the IBs in GCC only. For example, the data available in Dubai Islamic Bank’s annual report was limited to the financial reports only. Thus, any findings related to Shariah governance and audit in Dubai Islamic bank were very limited. Other researches could be conducted to obtain input related individuals that directly involved with Shariah audit practices. 26
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